Sunday, January 31, 2010

The federal government, in an effort to protect the purchasing power of social security benefits, indexes those benefits to increases in the consumer price index for urban wage earners and clerical workers (CPI-W). There is concern, however, that the CPI-W may not accurately reflect the inflation experience of the elderly population. On average, the elderly spend relatively more on health care, whose price has tended to rise faster than overall prices. Other things being equal, that would suggest that the CPI-W tends to understate the inflation experience of the average elderly household. The Bureau of Labor Statistics (BLS) has developed an experimental price index to track inflation for the population aged 62 and older. The average annual rate of change between December 1982 and December 2009 for the experimental index was 3.2%; over the same period, the CPI-W rose at a 2.9% rate. No inflation measure for a large population group will exactly account for the experience of each member of that group. Differences in spending patterns, in combination with different rates of price change for all of the various goods and services included in the CPI, mean that individual inflation rate experiences may range significantly above or below the measured average.

The federal government, in an effort to protect the purchasing power of social security benefits, indexes those benefits to increases in the consumer price index for urban wage earners and clerical workers (CPI-W).1 There is concern, however, that the CPI-W may not accurately reflect the inflation experience of the elderly population. It has been asserted that the elderly face a higher inflation rate because they tend to spend a larger share of their household budget on goods and services whose prices have been rising faster than average. More to the point, it is argued that increases in social security benefits have not kept pace with increases in the prices of those goods and services purchased by the elderly, and that some other index might be more appropriate. As Congress takes up the issue of social security reform, one item of consideration may be the way in which benefits are indexed. Some may call for a change in the index, which is used to determine cost-of-living adjustments (COLAs) for benefits.

The CPI-W is published monthly by the Bureau of Labor Statistics of the Department of Labor (BLS). It is designed to measure changes in the prices of goods and services purchased by those who earn more than half of their income from clerical or wage occupations and have been employed at least 37 weeks in the previous year.2 This group accounts for about 32% of the total U.S. population. But the CPI-W only tracks the buying habits of the employed. To the extent that retirees' purchasing patterns differ from those of the rest of the population, the effect of inflation on their standard of living may be different from what is indicated by the CPI-W.

This CRS report can be ordered over the phone at (301) 253-0881 or by email at Penny Hill Press (congress@pennyhill.com). Be sure to include the document number for the fastest possible service. Please specify whether you want electronic delivery (pdf file or postal delivery).

Public-policy discussions often involve dollar amounts. Because of rising prices, however, the purchasing power of those dollar amounts changes over time. For that reason, policy makers have seen fit in some cases to arrange for those amounts to be increased automatically, as prices rise, to keep their purchasing power unchanged. Without such an arrangement, either the real value of those amounts would fall or policy makers would have to take periodic steps to increase them to offset the effects of inflation.

Most of the effect on the federal budget of automatic cost-of-living adjustments (COLAs) may be accounted for by three programs: individual income taxes, Social Security, and income support programs tied to the poverty thresholds.

The consumer price index (CPI) is used to make cost-of-living adjustments. It is based on prices and quantities of goods and services, which can be directly observed. It measures the change in income required to purchase a fixed market basket of goods and services, but that is not a "true" measure of change in the cost of living. A true cost-of-living index would measure the change in income required to maintain a constant level of satisfaction.

If existing measures of price change exaggerate what increase in income is needed to maintain consumer satisfaction, then increases in benefit payments that are indexed are larger than they need to be to maintain their value to beneficiaries, and income tax brackets shift upward more than necessary to avoid bracket creep. These bracket increases reduce federal revenues. Both effects tend to increase the budget deficit. There are other price indexes that may be superior measures of change in the "true" cost of living, but they have some practical disadvantages. One standard for choosing a price index for automatic COLAs might be which one is most appropriate. In some cases, it might be argued that what is appropriate is not a measure of price change but rather a measure of change in income.

With respect to public policy in general, it has been argued that indexation may have the effect of inhibiting policy makers from making changes to those programs that are indexed. It may be that indexing a benefit implies a kind of guarantee of future benefits, making any future change likely to be more contentious. It may be that there is a loss of policy discretion and an increase in policy inertia with respect to those programs that are indexed. Indexed benefits rise over time with no regard to changes in underlying economic conditions. However, budget priorities are constantly shifting, and if economic growth is sluggish and revenues are less than expected, that may put additional budgetary pressure on those programs that may be relatively more subject to discretion.

This CRS report can be ordered over the phone at (301) 253-0881 or by email at Penny Hill Press (congress@pennyhill.com). Be sure to include the document number for the fastest possible service. Please specify whether you want electronic delivery (pdf file or postal delivery).

Friday, January 29, 2010

Unemployment compensation (UC) benefits have been fully subject to the federal income tax since the passage of the Tax Reform Act of 1986 (P.L. 99-514). Individuals who receive UC benefits during a year may elect to have the federal (and in some cases state) income tax withheld from their benefits. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5 § 1007) includes a temporary exclusion on the first $2,400 of UC benefits for the purposes of the federal income tax. This exclusion exists only in 2009. The Joint Committee on Taxation estimates this would reduce federal receipts by approximately $4.7 billion.

There is no exclusion for 2010. Among its many provisions, S. 2831 would suspend the federal taxation of the first $2,400 of unemployment benefits through 2010.

This report provides an overview of the taxation of UC benefits and legislation related to taxing UC benefits. This report will be updated as legislative activity warrants. .

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

Government regulators, investment bankers, and others have testified at congressional hearings that a significant volume of commercial mortgages could default, causing major losses for commercial banks, savings institutions, life insurance companies, government-sponsored enterprises (GSEs), and issuers of commercial mortgage-backed securities (CMBS). These losses, coming after losses on residential mortgages and other loans, have the potential to further reduce the capital of lenders, perhaps leading to additional bank closings. The closings could require the Federal Deposit Insurance Company (FDIC) to honor its insurance on deposits. The FDIC could act in ways that would protect uninsured deposits, but this would cost the government additional money.

According to recent statistics, there are $3.4 billion in commercial mortgages outstanding with $500 billion maturing in the next few years. One investment banker testified to the Joint Economic Committee that losses for one type of commercial mortgage financing (commercial mortgage-backed securities) could reach 9%-12% or $65 billion to $90 billion; in the real estate bust of the early 1990s, the worst performing groups of mortgages were around 10%. This suggests that commercial mortgage losses could be as bad as those in the early 1990s. Some commercial real estate will be more affected by mortgage losses than others. For example, FDIC statistics suggest that small banks (those with less than $1 billion in assets) are relatively more exposed to commercial real estate loans and losses than are large banks.

Treasury Secretary Timothy Geithner has expressed the belief that the commercial mortgage losses can be handled with the tools available. This report discusses the severity of the problems the commercial mortgages may cause the financial system, the tools available to reduce these problems, and some areas for possible congressional oversight. This report will be updated as warranted.

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

Martin A. Weiss, CoordinatorSpecialist in International Trade and Finance

Extensive congressional focus on the International Financial Institutions (IFIs) may continue during the 111th Congress, due to the IFI's intensive involvement in global efforts to recover from the global financial crisis. Developing countries were particularly hard-hit by the crisis. The financial crisis led to a contraction in global trade, reduced demand for primary product exports, and a drop in global capital flows. The result of these trends is lower levels of economic growth and increased poverty in many developing countries. Whereas many advanced and some emerging market economies have used fiscal spending to stimulate their economies, most developing countries have not been able to afford this level of stimulus spending.

In addition to focusing on the crisis's impact on developing countries, concerns about international financial stability and economic development led to an increased focus on the IFI's global macroeconomic surveillance efforts. To improve these efforts, leading member countries agreed to increase the shares and votes of major developing countries. Moreover, as of fall 2009, the Group of 20 nations is the leading forum for major international economic coordination activities

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

Thursday, January 28, 2010

Raising revenue to finance the federal government is a fundamental constitutional responsibility of the Congress. And, in dealing with the federal tax system, Members recognize that beyond funding the government, the tax system significantly affects individual taxpayers as well as the economy as a whole. Further, as with previous Congresses, the 111th Congress will undoubtedly be mindful of the need to seek equitable treatment of families in any tax changes they contemplate.

In crafting tax provisions affecting families, Congress is likely to focus on the incentive (and disincentive) effects generally associated with family oriented tax policy as well as equity concerns. The tax legislation passed in the 107th, 108th, and 109th Congresses included a variety of family tax related provisions (in addition to reducing individual income tax rates and adding a 10% income tax bracket amount). In particular, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) changed the bracket amounts and standard deduction for married couples filing jointly and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-27) accelerated the increase in the child tax credit. The rate brackets and deduction amounts were adjusted by Congress to eliminate the so-called "marriage penalty," which in turn increased the companion "marriage bonus."

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

The financial crisis has renewed interest in the role of the Federal Reserve (Fed). Besides its traditional role of setting interest rates, currently at low levels intended to stimulate the economy in the recession, the Fed has taken unprecedented policy actions in its lender of last resort role. It has expanded its direct lending programs to non-member banks through an array of new lending facilities. It has purchased financial securities and intervened to support certain financial instruments. It has provided financial assistance to keep "too big to fail" financial institutions solvent. It has financed these operations by more than doubling its balance sheet. In 2009, the Fed began to wind down many of its emergency programs and replaced those loans on its balance sheet with debt and mortgage-backed securities issued by the housing government-sponsored enterprises (GSEs). As Congress considers proposals to reform financial regulation, it is debating whether the Fed's powers should be expanded or reduced.

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

The federal government and Congress influence the tax and spending decisions of state and local governments in several ways. First, the federal government transferred roughly $650 billion to state and local governments in the last fiscal year for a variety of spending initiatives, some accompanied by federal mandates. Second, the federal tax code includes many provisions that aid state and local government more indirectly, such as the deduction for state and local taxes paid and the exemption from federal income taxes of the interest paid on state and local government bonds. These transfers are accounted for as tax expenditures in contrast to direct expenditures. Third, Congress oversees interstate commerce and will sometimes intercede in state and local tax and trade issues. In addition, changes in federal taxes often impact state and local government taxes indirectly such as changes to federal estate taxes and corporate income taxes. Fourth, tribal areas are subject to a unique set of tax laws that sometimes challenge existing federal oversight.

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

Government-sponsored enterprises (GSEs) are congressionally-chartered financial institutions provided with special privileges to carry out narrow missions of critical public policy importance. Three GSEs—Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System—provide liquidity to home mortgages. The Farm Credit System and Farmer Mac, which are concerned with agricultural and certain rural housing loans, are also GSEs.

In September 2008, the federal government placed Fannie Mae and Freddie Mac in conservatorship. Since then, Treasury has purchased more than $100 billion in preferred stock and the Federal Reserve has purchased more than $1 trillion in mortgage-backed securities. These actions and the risk to the economy represented by the more than five trillion dollar combined mortgage guarantees of the three housing GSEs have meant increased congressional focus directed at how they are regulated and how they are operating. New legislation and oversight hearings are likely in the second session of the 111th Congress.

You can order this item by phone at (301) 253-0881 or by email at Penny Hill Press, Inc.. Be sure to include the document number. Specify whether you want electronic delivery (pdf file or postal delivery).

Tuesday, January 26, 2010

During some recessions, current taxes and reserve balances were insufficient to cover state expenditures for unemployment compensation (UC) benefits. UC benefits are an entitlement, and states are legally required to pay benefits even if the state account is insolvent. Some states may borrow funds from the Federal Unemployment Account (FUA) within the Unemployment Trust Fund (UTF) in order to meet UC benefit obligations. The 2009 stimulus package (The American Recovery and Reinvestment Act of 2009, P.L. 111-5 § 2004) temporarily waives interest payments and the accrual of interest on these loans to states from the FUA.

This report summarizes how insolvent states may borrow funds from the federal account within the UTF in order to meet their UC benefit obligations. Outstanding loans listed by state may be found at the Department of Labor's website: http://www.workforcesecurity.doleta.gov/unemploy/ budget.asp#tfloans.

Michigan has just completed its first year of a credit reduction. As a result, the credit reduction was applied retroactively to tax year 2009 earnings and the net FUTA tax during 2009 for Michigan employers is 1.1% on the first $7,000 of each employee's earnings. No other state currently has a credit reduction; thus, in all other states the net FUTA 2009 tax was 0.8%. This report will be updated to reflect major changes in state UTF account solvency.

Total debt of the federal government can increase in two ways. First, debt increases when the government sells debt to the public to finance budget deficits and acquire the financial resources needed to meet its obligations. This increases debt held by the public. Second, debt increases when the federal government issues debt to certain government accounts, such as the Social Security, Medicare, and Transportation trust funds, in exchange for their reported surpluses. This increases debt held by government accounts. The sum of debt held by the public and debt held by government accounts is the total federal debt. Surpluses generally reduce debt held by the public, while deficits raise it.

A statutory limit has restricted total federal debt since 1917 when Congress passed the Second Liberty Bond Act. Congress has raised the debt limit eight times since 2001. Deficits each year since 2001 and the persistent increases in debt held by government accounts repeatedly raised the debt to or near the limit in place at the time. Congress raised the limit in June 2002, and by December 2002 the U.S. Department of the Treasury asked Congress for another increase, which was passed in May 2003. In June 2004, the Treasury asked for another debt limit increase. After Congress recessed in mid-October 2004 without acting, the Secretary of the Treasury told Congress that the actions he was taking to avoid exceeding the debt limit would suffice only through mid-November. Congress approved a debt limit increase in a post-election session, which the President signed on November 19, 2004.

In 2005, Congress included debt limit raising reconciliation instructions in the FY2006 budget resolution (H.Con.Res. 95). With no action having been taken by December 2005, the Secretary of the Treasury sent several letters warning Congress that the Treasury would exhaust its options to avoid default by mid-March 2006. Congress passed an increase in mid-March, which the President signed on March 20. The House's adoption of the conference report on the FY2008 budget resolution in the spring of 2007 automatically created and deemed passed legislation (H.J.Res. 43) raising the debt limit by $850 billion to $9,815 billion. The Senate approved the resolution on September 27, 2007, and it was signed by the President two days later.

The current economic slowdown led to sharply higher estimates of the FY2008 and FY2009 deficits, which led to a series of debt limit increases. A debt limit increase was included in the Housing and Economic Recovery Act of 2008 (H.R. 3221) and signed into law (P.L. 110-289) on July 30. The Emergency Economic Stabilization Act of 2008 (H.R. 1424), signed into law on October 3 (P.L. 110-343), raised the debt limit again. The debt limit was increased for the third time in less than a year with the passage of American Recovery and Reinvestment Act of 2009 on February 13, 2009 (ARRA; H.R. 1), which was signed into law on February 17, 2009 (P.L. 111- 5), which raised the debt limit to $12,104 billion.

The House's adoption of the conference report on the FY2010 budget resolution (S.Con.Res. 13) on April 29, 2009, triggered the automatic passage of a separate measure (H.J.Res. 45) to raise the debt limit to $13.029 trillion that was then sent to the Senate. In August 2009, according to media reports, Secretary of Treasury Timothy Geithner notified Congress that the debt limit would be reached in mid-October, although the Treasury later stated that the limit would not be reached until mid or late December 2009. H.R. 4314, passed by the House on December 16, 2009, and by the Senate on December 24, raised the debt limit to $12.394 trillion when the President signed the measure (P.L. 111-123) on December 28. This report, written with the assistance of Joseph McCormack, will be updated as events warrant.

Under the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16), the estate tax is repealed for decedents dying in 2010. The gift tax, associated with the estate tax, is scheduled to remain in place in 2010, with a cumulative lifetime exclusion of $1 million (above and beyond the annual gift exclusion of $13,000 per donor per recipient) and a maximum tax rate of 35%. Also for 2010 only, the method used to determine the "basis" of all capital assets transferred at death is a modified carryover basis, instead of a step-up in basis.

The estate tax repeal is scheduled to sunset, or expire, on December 31, 2010. If Congress does not change the law beforehand, on January 1, 2011, estate and gift tax law will return to what it would have been had EGTRRA never been enacted. The unified estate and gift tax would be reinstated with a combined exclusion of $1 million. The maximum tax rate would revert to 55% (plus a 5% surtax on taxable estate value from $10 million to $17 million).

Sunday, January 24, 2010

According to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), the U.S. economy has been in recession since December 2007. Congress passed and the President signed an economic stimulus package, the American Recovery and Reinvestment Act of 2009 (P.L. 111-5), in February 2009. The $787 billion package included $286 billion in tax cuts to help stimulate the economy. Among the tax reductions, many were tax incentives directed to business. The preliminary estimate of third quarter real gross domestic product (GDP) growth is 2.8%; the unemployment rate, a lagging indicator, averaged 9.6% in the third quarter and 10.0% in the fourth quarter of 2009. Federal Reserve Chairman Ben Bernanke expects the economy to continue growing at a modest pace, but predicts that bank lending will remain constrained and the job market will remain weak into at least 2010. To further assist unemployed workers, help business, and stimulate housing markets, Congress passed the Worker, Homeownership, and Business Assistance Act of 2009 (P.L. 111-92). The Obama Administration has advocated further business tax incentives to spur investment and employment, especially for small business.

The two most common measures to provide business tax incentives for new investment are investment tax credits and accelerated deductions for depreciation. The evidence, however, suggests that a business tax subsidy may not necessarily be the best choice for fiscal stimulus, largely because of the uncertainty of its success in stimulating aggregate demand. If such subsidies are used, however, the most effective short-run policy is probably a temporary investment subsidy. Permanent investment subsidies may distort the allocation of investment in the long run.

Employment and wage subsidies are designed to increase employment directly by reducing a firm's wage bill. The tax system is a frequently used means for providing employment subsidies. Most of the business tax incentives for hiring currently under discussion are modeled partially on the New Jobs Tax Credit (NJTC) from 1977 and 1978. Evidence provided in various studies suggests that incremental tax credits have the potential of increasing employment, but in practice may not be as effective in increasing employment as desired. There are several reasons why this may be the case. First, jobs tax credits are often complex and many employers, especially small businesses, may not want to incur the necessary record-keeping costs. Second, since eligibility for the tax credit is determined when the firm files the annual tax return, firms do not know if they are eligible for the credit at the time hiring decisions are made. Third, many firms may not even be aware of the availability of the tax credit until it is time to file a tax return. Lastly, product demand appears to be the primary determinant of hiring.

In December 2001, following an extended period of economic and political instability, Argentina suffered a severe financial crisis, leading to the largest default on sovereign debt in history. It was widely recognized that Argentina faced an untenable debt situation that was in need of restructuring. In 2005, after prolonged, contentious, and unsuccessful attempts to find a mutually acceptable solution with its creditors, Argentina abandoned the negotiation process and made a one-time unilateral offer on terms highly unfavorable to the creditors. Although 76% of them accepted the offer, a diverse group of "holdouts" opted instead for litigation in hopes of achieving a better settlement in the future. Although Argentina succeeded in reducing much of its sovereign debt, its unorthodox methods have left it ostracized from international credit markets for nearly a decade and triggered legislative action and sanctions in the United States.

Argentina still owes private creditors $20 billion in defaulted debt and $10 billion in past-due interest, as well as $6.2 billion to Paris Club countries. Of the disputed privately held debt, U.S. investors hold approximately $3.0 billion. Some of the more vocal investor groups have lobbied Congress to pressure Argentina to reopen debt negotiations. Some Members of Congress have introduced punitive legislation in both the 110th and 111th Congress, but to date it has not received any legislative action. Nearly five years after the original debt workout, however, a confluence of circumstances has persuaded Argentina to restructure the holdout debt, particularly the need to secure long-term public financing.

On December 16, 2009, Argentina filed a registration statement and prospectus to issue $15 billion in bonds, the proceeds of which will be used to finance an exchange of defaulted debt. The terms of exchange were not included and are not expected until late January 2010. Some analyses speculate that the structure of the new exchange will be similar to the one offered in 2005, which would entail a discount of 65% from the face value of the bonds, with past due interest capitalized and financed separately. Given that Argentine law prohibits the new exchange from offering better terms than the 2005 offer, and that bondholders who participated in that exchange benefitted from additional payments based on Argentina's strong economic growth, it appears likely that the new offer will be the less favorable of the two.

For Argentina, a successful restructuring requires a sufficiently large participation rate for the courts to set aside existing judgments and attachment orders. This action would allow Argentina renewed access to the international credit markets. Historically, sovereign debt workouts with at least a 90% participation rate have achieved this goal. Since holdouts compose 24% of the original bondholders, a 60% participation rate of this group would allow for the total participation rate to reach the 90% threshold. If the exchange succeeds, Argentina will have completed a debt restructuring with the deepest write-off of principal in history. The original bondholders were severely hurt by this deal, but so was Argentina by the crisis. It appears that nothing can be done for the original investors who have traded their bonds. If there is a legacy to the Argentine case, it may be in the changes to bond contracts that seek to improve outcomes for creditors. One option is collective action clauses (CACs) in bonds, which require all creditors to bargain collectively, with a compulsory majority decision applicable to all bondholders. This provision may allow for more coordinated creditor responses, which could increase their bargaining leverage, allow for more equitable treatment of all bondholders, and lead to a far quicker resolution to any future sovereign default.

The budget deficit equaled $1.4 trillion in FY2009, compared with $455 billion in 2008. Under current policy, it is projected to remain nearly that large in 2010. As a share of gross domestic product (GDP), the 2009 deficit was the largest since World War II. A deficit this large is unsustainable in the long run in the sense that maintaining it would cause the national debt to grow continuously as a share of GDP. According to mainstream economic theory, the deficit has a negative effect on the economy in the long run through effects on interest rates, national saving, and the trade deficit, but in the short-run economic theory also suggests that it can mitigate a deep recession. The policy dilemma is in the timing—reducing the deficit before investors become concerned about sustainability, but not so soon that it exacerbates the recession or stifles out an incipient recovery. In the long run, the deficit is projected to grow under current policy as entitlement spending increases relative to GDP. Official baseline projections of the deficit are likely to be biased downward due to formulaic assumptions.

On January 12, 2010, a magnitude 7.0 earthquake struck Haiti. As of January 20, 2010, 72,000 had been confirmed dead with hundreds of thousands more in need of assistance. The earthquake has left an estimated 1.5 million Haitians homeless. Congress has passed legislation with the goal of promoting charitable donations for the earthquake victims in Haiti. Similar action was taken following the 2004 Indian Ocean tsunami and the 2005 Gulf Coast Hurricanes, when Congress enacted legislation to promote charitable giving to organizations providing aid to victims of these natural disasters.

On January 20, 2010, the House passed the Haiti Assistance Income Tax Incentive Act (HAITI Act; H.R. 4462), a bill to accelerate the income tax benefits for charitable cash contributions for the relief of earthquake victims. The Senate introduced companion legislation (S. 2936) on January 20, 2010, but passed the identical House legislation H.R. 4462 on January 21, 2010. If enacted, the HAITI Act would allow taxpayers making charitable contributions of cash made to organizations providing aid to earthquake victims after January 11, 2010, and before March 1, 2010, to take the associated charitable deduction on their 2009 income tax returns. A similar provision, discussed in greater detail below, was adopted under P.L. 109-1 following the 2004 Indian Ocean tsunami. The Joint Committee on Taxation (JCT) estimates that the HAITI Act would result in revenue losses of approximately $2 million over the 10-year budget window spanning FY2010 through FY2019.

Under current law, charitable contributions to 501(c)(3) charitable organizations from individuals, corporations, and estates and trusts are tax deductible in the year they are made. Individuals can deduct up to 50% of their adjusted gross income (AGI), phased-out for higher income individuals. Corporations can deduct up to 10% of their taxable income. Individuals and corporations can carry forward any unclaimed charitable deductions for up to five years. Total charitable giving in 2008 was $307.65 billion.

In the past, Congress has passed legislation to encourage charitable giving following natural disasters. Following the 2004 Indian Ocean tsunami, legislation was passed that allowed taxpayers making charitable contributions to aid tsunami victims in January 2005 to take the charitable deduction on their 2004 tax return. This provision is similar to the one proposed in the HAITI Act. In September 2005, following Hurricane Katrina, individual and corporate giving limits were suspended. The rules surrounding charitable contributions of food inventory and books were also relaxed to encourage in-kind giving.

The HAITI Act, like other tax policies, can be evaluated along the dimensions of efficiency and equity. Efficiency is greatest when the policy's marginal impact, the giving induced by the program, is large relative to the policy's inframarginal impact, the benefits given to those whose behavior was not directly caused by the tax policy. Using this framework, the HAITI Act is unlikely to be economically efficient. In general, tax benefits for charitable giving do not appear to significantly increase donations. Furthermore, tax deductions violate principles of vertical equity in that the benefits of tax deductions accrue disproportionately to higher income groups and provide larger benefits to those with a greater ability to pay.

Thursday, January 21, 2010

Several tax options have been proposed to provide financing for health care reform. President Obama has proposed restricting itemized deductions for high-income taxpayers, along with some narrower provisions. H.R. 3962 passed in the House on November 14, 2009; its largest source of increased revenues is from additional income taxes for higher-income taxpayers. On December 24, 2009, the Senate adopted H.R. 3590, whose revenue provisions are similar to those in the bill reported by the Senate Finance Committee (S. 1796). Taxing insurance companies on high-cost employer plans is the largest single source of revenue in that plan. Both plans include health related provisions, including fees or excise taxes, along with some other provisions.

Several proposals for revenue, considered during the health care financing debate of 2009, have not been included in legislation reported out by congressional committees. These proposals include eliminating tax benefits from the exclusion of employer-provided health insurance, which has a significant revenue potential, and limiting tax savings to 28% of itemized deductions for the top two brackets, which was the centerpiece of the President's health reform tax proposals.

These provisions differ in their potential revenue gain, and behavioral and distributional effects. Some proposals are progressive (imposing higher relative burdens on higher income groups), some impose larger relative burdens on lower-income families, and some tend to fall on middleclass groups. The distributional analysis, however, relates only to finance: the total health care program may redistribute in favor of lower-income families even if the revenue sources do not.

The House bill (H.R. 3962) includes a high-income surtax of 5.4% on income above $1,000,000 (income levels are 50% as large for singles). The proposal would initially raise more than $30 billion per year. One concern that has been raised about this surtax is the effect on small business, entrepreneurship, and job creation; however, much of this income is passive income or income of professions (e.g., stockbrokers, doctors). The proposal also includes some narrower, largely corporate provisions and restrictions on health-related tax expenditures. The Senate bill (H.R. 3590) would impose an excise tax on insurance companies for high-cost employer plans. Most of the remaining revenue is raised from restricting health-related tax expenditures; increasing the Medicare payroll tax for high-income earners; and imposing fees on medical devices, branded drugs, and health insurance providers.

Witnesses in a round-table discussion held by the Senate Finance Committee in 2009 also discussed a number of other options, including other base broadening provisions as well as rate increases for the individual income tax, increases in payroll taxes, and new revenue sources such as a value added tax (VAT) and a cap and trade auction system for carbon emission permits.

An issue in the development of the new health care reform legislation is the effect on small business. One concern is the effect of a "pay or play" mandate to require firms to provide health insurance for their employees or pay a penalty. Current proposals have exemptions for small businesses, and also propose to provide subsidies for purchasing insurance. Economic theory suggests that health insurance costs (and any penalties) should be passed on to labor income, but that may be more difficult for employers of lower-wage workers. Furthermore, average wages are generally smaller for small firms (except for the smallest). A second concern is the potential effect of the surcharge on high-income individuals, which has been proposed as a funding mechanism in the House proposal, and its effects on owners of small businesses.

Both the House bill (H.R. 3962, passed on November 14, 2009) and the Senate bill (H.R. 3590, passed on December 24, 2009) would exempt small businesses from penalties. The House bill would apply no penalties to firms with $500,000 or less in payroll, and the Senate bill would exempt firms with 50 or fewer employees. As a result, very few smaller businesses would be affected. The House bill would exempt over 80% of firms and the Senate bill would probably exempt about 95%. The House plan would exempt fewer firms over time because the exemption is not indexed. The share of firms that would not be affected either because they are exempt or because they already offer insurance would be larger, probably around 95% to 98%. About 20% of employees work for firms that were estimated to be affected.

The penalties in the Senate bill are per-employee flat dollar amounts of $750 for firms that do not offer coverage, triggered if one or more employees are eligible for the premium credit for lower income families. They are relatively small compared with the cost of health insurance. Firms that offer insurance also will pay penalties if their employees enroll in individuals plans and receive the premium credit, only for those employees. The penalties appear smaller than those in the House proposals, which are calculated as a percentage of payroll. The proposals also provide temporary credits to subsidize small employers' contributions to insurance for lower-income employees that depend on firm size and employee compensation. The credits are the same in the two bills (except that the Senate bill allows a higher compensation phaseout), and would be as much as 50% of the employer's cost. The subsidy for taxable firms is provided as a nonrefundable income tax credit and would not benefit firms with no income tax liability; the Senate bill, however, has a separate 35% credit for nonprofits.

Because most small businesses are subject to the individual income tax, high-income business owners could be affected by the proposed surcharge that would be imposed (for couples) at 5.4% on incomes over $1 million ($500,000 for singles) in the House bill. The surcharge affects 0.3% of taxpayers; 1.2% of unincorporated businesses are affected. Concerns have been raised that the surcharge on adjusted gross income would have adverse effects on small business and, in turn, on job creation. The top 1% of taxpayers receive more than half of the income of unincorporated business, but some income is passive (reflecting investment rather than operating a business). Some is active income received by professional services (e.g., doctors, attorneys, financial advisors). These activities may be less related to job creation, often associated with new entrepreneurial firms. The job creation justification is problematic on several grounds. It would be possible to exclude certain types of business income from the surcharge at a small cost if passive income and certain income (e.g., finance, insurance, real estate, professional services) were not eligible for the exclusion.

Several bills introduced in the 111th Congress addressed the recently recognized phenomenon of patented tax strategies. These legislative initiatives would prevent the grant of exclusive intellectual property rights by the United States Patent and Trademark Office (USPTO) on methods that individuals and enterprises might use in order to minimize their tax obligations.

Many commentators trace the rise of tax strategy patents to the 1998 opinion of the Federal Circuit in State Street Bank v. Signature Financial Group, which rejected a per se rule that business methods could not be patented. In recent years, the USPTO has issued a number of patents that pertain to tax strategies, and numerous other patent applications remain before that agency. At least one of these patents, the so-called SOGRAT patent, has been subject to enforcement litigation in federal court.

The impact of tax strategy patents upon social welfare has been subject to a spirited debate. Some observers are opposed to tax strategy patents. These commentators believe that patent protection is unnecessary with respect to tax avoidance techniques due to a high level of current innovation. Others believe that patent-based incentives to develop tax avoidance strategies are not socially desirable. They assert that patents may limit the ability of individuals to utilize provisions of the tax code intended for all taxpayers, interfering with congressional intent and leading to distortions in tax obligations. Others have expressed concerns that tax strategy patents may potentially complicate legal compliance by tax professionals and individual taxpayers alike.

Other experts believe that these concerns are overstated, and also make the affirmative case that tax strategy patents may provide positive social benefits. They explain that patents on "business methods" have been obtained and enforced for many years. They also observe that the grant of a patent does not imply government approval of the practice of the patented invention, and that professionals in many spheres of endeavor have long had to account for the patent system during their decision-making process. They also believe that the availability of tax strategy patents may promote innovation in a field of endeavor that is demonstrably valuable. Further, such patents might promote public disclosure of tax strategies to tax professionals, taxpayers, and responsible government officials alike.

Three bills introduced in the 111th Congress—H.R. 1265, H.R. 2584, and S. 506—would prohibit the issuance of patents on tax strategies. Other legislative responses, including oversight of the USPTO, promotion of cooperation between the USPTO and the IRS, and the encouragement of private sector contributions to the patent examination process, are also possible.

The federal government levies an estate tax on the net value of assets transferred to individuals (other than the surviving spouse) upon a person's death. Under provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16), for people who died in 2009, the applicable exclusion amount (exemption) under the estate tax was $3.5 million per decedent, and the maximum estate tax rate was 45%. For people who die in 2010, there is no estate tax. However, the gift tax, associated with the estate tax, is scheduled to remain in place in 2010, with a cumulative lifetime exclusion of $1 million (above and beyond the annual gift exclusion of $13,000 per donor per recipient) and a maximum tax rate of 35%. In addition, when the estate tax is repealed in 2010, there is scheduled to be a significant change in the method used to determine the "basis" of all capital assets transferred at death—from "step-up in basis" to "modified carryover basis."

The estate tax provisions of EGTRRA are scheduled to sunset at the end of 2010. If Congress does not change the law beforehand, on January 1, 2011, estate and gift tax law will return to what it would have been had EGTRRA never been enacted. The unified estate and gift tax would be reinstated with a unified (combined) exclusion of $1 million. The maximum tax rate would rise back to 55%, plus a 5% surtax on taxable estate value from $10.0 million to $17.184 million.

The Obama Administration's federal budget proposal for FY2010 proposed to permanently extend 2009 estate tax law, and the extension was not classified as a tax cut. The concurrent budget resolution that Congress adopted for FY2010 (S.Con.Res. 13) on April 29, 2009, provided budget room for the permanent extension of 2009 estate tax law. H.R. 2920, the Statutory Pay-As- You-Go Act of 2009, as passed by the House on July 22, 2009, states explicitly that the extension of 2009 estate tax law is not an item that would need to be paid for under the statutory pay-go rules being proposed in the bill.

Numerous bills were introduced in the first session of the 111th Congress either to permanently repeal the estate tax, or to retain the estate tax but modify it. The three most frequently mentioned proposals for extending the estate tax were a one-year extension of 2009 law; a permanent extension of 2009 law; and a permanent extension of the estate tax, but with a $5 million exemption and a maximum tax rate of 35%.

On December 3, 2009, the House passed H.R. 4154 by a vote of 225-200. Division A of H.R. 4154 is the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. It would permanently extend 2009 estate tax law effective January 1, 2010. The estate tax exemption would remain at $3.5 million per decedent; the exemption amount would not be indexed for inflation. The top estate tax rate would remain at 45%. Division B of H.R. 4154 is the Statutory Pay-As-You-Go Act of 2009 that was previously adopted by the House on July 22, 2009, as H.R. 2920. On December 16, 2009, the Senate decided not to act on the estate tax in 2009. The Senate is expected to address the estate tax in 2010, during the second session of the 111th Congress.

In December 2009, the Joint Committee on Taxation estimated the 10-year revenue loss from extending 2009 estate tax law, relative to current law, at $234 billion for FY2010-FY2019. This estimate does not include any interest cost associated with deficit-financing the loss of revenue. In March 2009, Treasury estimated estate and gift tax revenue under the proposal to be $266 billion over the same 10-year-period. This report will be updated as legislative events warrant.

One clear lesson of the 2008 recession, which brought Goliaths such as Bear Sterns, CitiGroup, AIG, and Washington Mutual to their knees, is that no financial institution, regardless of its size, complexity, or diversification, is invincible. Congress, as a result, is left with the question of how best to handle the failure of systemically significant financial companies (SSFCs). In the United States, the insolvencies of depository institutions (i.e., banks and thrifts with deposits insured by the Federal Deposit Insurance Corporation (FDIC)) are not handled according to the procedures of the U.S. Bankruptcy Code. Instead, they and their subsidiaries are subject to a separate regime prescribed in federal law, called a conservatorship or receivership. Under this regime, the conservator or receiver, which generally is the FDIC, is provided substantial authority to deal with virtually every aspect of the insolvency. However, the failure of most other financial institutions within bank, thrift, and financial holding company umbrellas (including the holding companies themselves) generally are dealt with under the Bankruptcy Code.

During the 111th Congress, there have been calls to revamp the resolution process for systemically significant financial institutions. Some of these proposals, such as H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009, and the Obama Administration's "Resolution Authority for Systemically Significant Financial Companies Act of 2009," would establish resolution regimes modeled after the FDIC's conservatorship/receivership authority. Other proposals, like H.R. 3310, the Consumer Protection and Regulatory Enhancement Act, would resolve these firms through a special provision of the Bankruptcy Code. In order to make a policy assessment concerning the appropriateness of these proposals, it is important to understand both the similarities and differences between insured depositories and other financial institutions large enough or interconnected enough to pose systemic risk to the U.S. economy upon failure, as well as the differences between the Bankruptcy Code and the FDIC's conservatorship/receivership authority.

This report first discusses the purposes behind the creation of a separate insolvency regime for depository institutions. The report then compares and contrasts the characteristics of depository institutions with SSFCs. Next, the report provides a brief analysis of some important differences between the FDIC's conservatorship/receivership authority and that of the Bankruptcy Code. The specific differences discussed are: (1) overall objectives of each regime; (2) insolvency initiation authority and timing; (3) oversight structure and appeal; (4) management, shareholder, and creditor rights; (5) FDIC "superpowers," including contract repudiation versus Bankruptcy's automatic stay; and (6) speed of resolution. This report makes no value judgment as to whether an insolvency regime for SSFCs that is modeled after the FDIC's conservatorship/receivership authority is more appropriate than using (or adapting) the Bankruptcy Code. Rather, it points out the similarities and differences between SSFCs and depository institutions, and compares the conservatorship/receivership insolvency regime with the Bankruptcy Code to help the reader develop his/her own opinion. .

Concerns over global climate change and energy security have led to sustained Congressional interest in energy tax policy. This interest is expected to continue in the second session of the 111th Congress. Constraining the options for addressing these issues are substantial budget deficits, which may spur Congress to consider revenue neutral or revenue raising policies while debating energy tax policy initiatives.

Options for addressing global climate change examined during the first session are likely to be revisited during the second session. The probable starting point for this debate will be further work on cap-and-trade legislation (H.R. 2454, S. 1462) considered during the first session of the 111th Congress. Using market-based mechanisms, such as cap-and-trade programs or a carbon tax, to control CO2 emissions will remain part of the discussion. Given the uncertainty surrounding the state of the U.S. economy and the economic recovery, Congress may want to evaluate the economic impact that a cap-and-trade program could have on growth, industry and business development, and low-income individuals.

Wednesday, January 20, 2010

In the aftermath of the recent financial crisis, broad financial regulatory reform legislation has been advanced by the Obama Administration and by various Members of Congress. Under the McCarran-Ferguson Act of 1945, insurance regulation is generally left to the individual states. For several years prior to the financial crisis, some Members of Congress have introduced legislation to federalize insurance regulation along the lines of the regulation of the banking sector, although none of this legislation has reached the committee markup stage.

The financial crisis, particularly the role of insurance giant AIG and the smaller monoline bond insurers, changed the tenor of the debate around insurance regulation, with increased emphasis on the systemic importance of insurance companies. While it could be argued that insurer involvement in the financial crisis demonstrates the need for full-scale federal regulation of insurance, to date the broad financial regulatory reform proposals have not included language implementing such a system. Instead, broad reform proposals have tended to include the creation of a somewhat narrower federal office focusing on gathering information on insurance and setting policy on international insurance issues. Legislation proposed by the Obama Administration, Representative Paul Kanjorski (H.R. 2609 as incorporated into H.R. 4173), Representative Spencer Bacchus (H.Amdt. 539 to H.R. 4173), and Senator Christopher Dodd (committee print of the Restoring American Financial Stability Act of 2009), all contain slightly differing versions of such an office.

The broad reform proposals could also affect insurance through consumer protection or systemic risk provisions, though insurance is largely exempted from these aspects of the legislation as well. The Obama proposal exempts insurance from the proposed federal consumer protection agency's oversight, except for title, credit, and mortgage insurance. Insurers could be considered "tier 1 financial holding companies" and thus subject to Federal Reserve oversight and federal resolution authority. Representative Barney Frank's H.R. 4173 as passed by the House exempts all insurance from the federal consumer protection agency's purview. In limited circumstances, insurers under H.R. 4173 could be subject to additional regulation for systemic stability and federal resolution authority, although insurers would continue to be primarily subject to state guaranty fund resolution. Under Senator Dodd's committee print, systemically significant insurers could be subject to the new Agency for Financial Stability and federal resolution authority.

Finally, H.R. 4173 and the Dodd committee print include narrower insurance reform legislation regarding surplus lines insurance and reinsurance similar to H.R. 2572/S. 1363, which had previously passed the House.

The House of Representatives passed H.R. 4173 on December 11, 2009, by a vote of 223-202. The Senate Banking, Housing, and Urban Affairs Committee held a hearing on Senator Dodd's committee print on November 19, 2009, but has not officially acted further on the legislation.

Tuesday, January 19, 2010

Following the financial crisis, the budget deficit reached 10% of GDP in 2009, a level that cannot be sustained in the long run. Concerns about long-term fiscal sustainability depend on the projected future path of the budget, absent future policy changes. The retirement of the baby boomers, rising life expectancy, and the rising cost of medical care result in projections of large and growing budget deficits over the next several decades. Social Security outlays are projected to rise from 4.8% of gross domestic product (GDP) today to 6.0% of GDP in 2035, and Medicare and Medicaid outlays are projected to rise from 5.3% today to as much as 10.0% of GDP in 2035 and 12.7% of GDP in 2050. These increases in spending are not expected to subside after the baby boomers have passed away. Without any corresponding rise in revenues, this spending path would lead to unsustainably large and persistent budget deficits, which would push up interest rates and the trade deficit, crowd out private investment spending, and ultimately cause fiscal crisis.

To avoid this outcome, taxes would need to be raised or expenditures would need to be reduced. Altering taxes and benefits ahead of time would reduce the size of adjustments required in the future, if the proceeds were used to increase national saving. (Making changes ahead of time would also allow individuals time to adjust their private saving behavior.) National saving can be increased by using the proceeds to pay down the national debt, purchase financial securities, or finance individual accounts. But if the budget savings is offset by new spending or tax cuts, the government's ability to finance future benefits will not have improved. Individual accounts financed by increasing the budget deficit, however, would not increase national saving or reduce the government's fiscal imbalance and could exacerbate the government's fiscal imbalance over the 75-year projection.

Relatively small tax increases or benefit reductions could return Social Security to long-run solvency. Restraining the growth in Medicare and Medicaid spending is more uncertain and difficult, however. The projected increase in spending is driven more by medical spending outpacing general spending increases than by demographic change. But it is uncertain how to restrain cost growth because much of it is the result of technological innovation that makes new and expensive treatments available. If future medical spending grows more slowly than projected, then the long-term budget outlook improves dramatically. From a government-wide perspective, Social Security or Medicare trust fund assets cannot help finance future benefits because they are redeemed with general revenues at a time when the overall budget is in deficit.

The reason revenues are not projected to rise along with outlays is that these programs are financed on a pay-as-you-go basis: current workers finance the benefits of current retirees. In the future, there will be fewer workers per retiree. Once a pay-as-you-go system is up and running and faced with an adverse demographic shift, there is no reform that can avoid making some present or future generation receive less than past generations. Under current policy, future generations will be made worse off by higher taxes or lower benefits. Under a reform that increases national saving, some of that burden would be shifted to current generations. Overall, current budget deficits negate the system's limited existing prefunding, exacerbating the future fiscal shortfall. While entitlement spending on the elderly is the major driver behind future deficits, it played little part in the growth of the current budget deficit. Reducing the current deficit is the most straightforward and concrete step that can be taken today to reduce the future shortfall.

Sunday, January 17, 2010

The amount of money saved has important economic consequences. Nationally, the amount of saving affects how much can be invested and ultimately the size of the capital stock. Increasing the size of the capital stock is believed to be one way to raise the productivity of the labor force. Individually, saving is critical to accumulating sufficient wealth to maintain living standards after retirement. This report explains how national saving is measured, presents recent estimates of saving rates in the United States, and, for comparison, provides those of other major industrial countries. This report will be updated periodically.

Following a boom and bust in real estate and a meltdown in financial markets, Congress enacted a program to purchase troubled assets from financial institutions in October 2008. The Troubled Asset Relief Program (TARP) was created by the Emergency Economic Stabilization Act (EESA, P.L. 110-343). Under TARP, the Secretary of the Treasury is authorized to purchase up to $700 billion of "troubled" assets, including any asset that the Secretary, in consultation with the Chairman of the Federal Reserve, believes the purchase of which will contribute to financial stability. The amount outstanding under TARP is currently far below this limit, and Treasury has announced plans for no more than $550 billion to be outstanding in the future.

Some policymakers have proposed redirecting funds under the Troubled Asset Relief Program to finance new policy proposals. The Helping Families Save Their Homes Act (S. 896/P.L. 111-22), redirected $1.3 billion from TARP to finance modifications to the Hope for Homeowners Program. The Wall Street Reform and Consumer Protection Act (H.R. 4173), which passed the House, would redirect $20.8 billion of TARP funds to offset $10.4 billion of various provisions of the bill. The Jobs for Main Street Act (H.R. 2847), which passed the House, would redirect $150 billion of TARP funds to offset $75 billion of the bill's spending and tax provisions.

When TARP was created, the Treasury did not collect and set aside $700 billion of revenue to finance the program—the Treasury Secretary was simply given legal authority to purchase $700 billion of assets. Therefore, Treasury holds no unused money under TARP that can be redirected toward new policy proposals. Like most spending programs, TARP expenditures are financed from general revenues. If the Treasury Secretary wished to purchase more TARP assets, it would be necessary to first issue federal debt (thereby increasing the budget deficit) to do so.

Proposals to redirect TARP funds to finance other proposals rely, in essence, on a reduction in the amount that the Treasury Secretary is authorized to purchase under TARP. Since TARP is not near its ceiling today, any proposal that reduces TARP authority by less than $150 billion would not force TARP asset holdings to be reduced from the currently planned size. Thus, reducing the authorized size of TARP by less than $150 billion does not increase the revenues flowing to the Treasury because it does not force Treasury to sell any of the assets TARP currently holds. In effect, a new policy proposal that increases spending or reduces revenues would be deficit financed if it included a reduction in TARP authority of less than $150 billion under Treasury's current plan (since it would not result in any increase in revenues via a reduction in TARP assets outstanding).

The scoring of proposals to redirect TARP funds, however, differs from the actual effect of these proposals. For official scoring purposes, the 2009 budget resolution instructs CBO to use the baseline from March 2009. This March baseline assumed all $700 billion of TARP authority would be used in the future, as opposed to the $550 billion currently planned by Treasury. Therefore, a bill financed by redirecting any TARP funds would officially be scored as being offset by a decline in overall anticipated federal spending via lower future TARP purchases, although under current Treasury plans, future TARP purchases would not actually be reduced. The offset would not be one-for-one, however. Under Section 123 of EESA, the cost of asset purchases are scored as the net present value of the subsidy in the loan, modified for risk, and are not scored on a cash flow basis. For future TARP spending, CBO assumes a subsidy rate of 50%. Therefore, a dollar reduction in TARP authority is scored as reducing the official budget deficit by only 50 cents.

Friday, January 15, 2010

The conservatorship of Fannie Mae and Freddie Mac raises questions about their impact on the housing and finance markets and their ability to return to financial viability: the federal government has purchased more than $110 billion in the two companies. Both companies are required under terms of the federal support to pay the government dividends of $11 billion annually (10% of the support). Housing, mortgage, and even general financial markets continue in an unprecedented situation.

The Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship after turmoil in the housing, mortgage, and financial markets raised doubts about the future of these enterprises, which are chartered by Congress as government-sponsored enterprises (GSEs) and whose debts are widely believed to be implicitly guaranteed by the federal government. The FHFA replaced the Office of Federal Housing Enterprise Oversight (OFHEO) as the GSEs' safety and soundness regulator. OFHEO repeatedly assured investors that Fannie and Freddie had adequate capital, but as highly leveraged financial intermediaries, Fannie Mae and Freddie Mac had limited capital to cushion them against losses.

The Treasury agreed to buy mortgage-backed securities (MBSs) from the GSEs and raise funds for them. Initially, each GSE gave Treasury $1 billion in senior preferred stock and warrants to acquire, at nominal cost, 80% of each GSE. Treasury has purchased slightly more than $112.6 billion of preferred stock in the two GSEs, and has agreed to invest whatever is required to maintain GSE solvency through calendar year 2012. Now the formerly implicit guarantee is nearly explicit.

In addition to Treasury's purchases of senior preferred stock, the Federal Reserve (Fed) has purchased GSE bonds and MBSs. According to a December 10, 2009, FHFA report, together the Fed and Treasury have purchased $1,199.8 billion in MBSs. This report will be updated as warranted.

Individual income tax provisions have shifted over time, first in increasing the burden on larger families, and then in decreasing it. These shifts were caused by changing tax code features: personal exemptions, standard and itemized deductions, rates, the earned income credit, the child credit, and other standard structural aspects of the tax. The distribution of tax burden across income classes has, however, changed relatively little, although burdens at the top and bottom have decreased in recent years. A recent proposal by Chairman Rangel of the Ways and Means Committee, H.R. 3970, proposes some important changes in family tax treatment, including an expansion in the earned income credit for families without children.

While several standards may be considered in determining equitable treatment of families over family type and size, a standard approach is based on ability to pay, so that large families with the same income as small ones pay less tax. Based on this standard, the analysis of equity across families suggests that families with children are paying lower rates of tax (or receiving larger negative tax rates) than single individuals and married couples at lower and middle incomes. However, families with children are being taxed more heavily at higher-income levels. At the lowest income levels, the EIC provides the largest tax subsidies to families with two or three children. The smallest subsidies go to childless couples. At middle-income levels, families with many children will have the most favorable treatment, due to the effect of the child credit, which has a very large effect relative to tax liability. At higher-income levels, large families are penalized because the adjustments for children such as personal exemptions and child credits are too small or are phased out, while graduated rates cause larger families that need more income to maintain a given living standard to pay higher taxes. Tax rates are more variable at lower-income levels. At all but the lowest and very highest income levels, singles pay higher taxes than married couples.

The analysis of the marriage penalty indicates that marriage penalties have largely been eliminated for those without children throughout the middle-income range, but this change has inevitably expanded marriage bonuses. Marriage penalties remain at the high and low income levels and could also apply to those with children, where the penalty or bonus is not very well defined. But by and large, the current system is likely to encourage rather than discourage marriage and favors married couples over singles.

The analysis of equity across families suggests that increases in earned income tax credits for those without children would lead to more equal treatment based on the ability to pay approach, while full refundability of the child credit would exacerbate inequalities. At the higher end of the scale, eliminating phaseouts of provisions that differentiate across families would probably lead to more equitable treatment, and containing the effect of the alternative minimum tax is important to both reducing the high burden of taxes on families with children at upper middle-income levels as well as preventing an increasing level of marriage penalties.

This report does not include the temporary provisions enacted in the American Recovery and Reinvestment Act of 2009 (P.L. 111-5), although a brief summary is provided in the introduction.

The 2001 tax revision began a phase out of the estate tax, by increasing exemptions and lowering rates. The estate tax is scheduled to be repealed in 2010 and a provision to tax appreciation on inherited assets (in excess of a limit) will be substituted. The 2001 tax provisions sunset, however, so that absent a change making them permanent the estate tax will revert, in 2011, to prior, pre- 2001 law. Proposals to make the repeal permanent, or to significantly increase the exemptions and lower the rate, are under consideration.

Discussions of the estate tax have focused particularly on the effects on family businesses, including farms, and the perception that the estate tax unfairly burdens family businesses because much of the estate value is held in illiquid assets (e.g., land, buildings, and equipment). The estate tax may even force the liquidation of family businesses. A special family business deduction, the Qualified Family Owned Business Interest Exemption (QFOBI) was enacted in 1997. Because of higher exemptions and a previous cap on the combined regular and small business exemption, this provision is no longer relevant. If, however, the estate tax repeal sunsets, QFOBI will again be germane.

On December 3, 2009, the House passed H.R. 4154, the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. H.R. 4154 makes the 2009 provisions, which allow a $3.5 million exemption and a 45% tax rate, permanent. In the Senate, leaders have indicated that they will consider estate tax legislation in 2010. Proposals considered in the Senate during the 111th Congress have included the extension of the 2009 estate tax provisions to 2010, permanently repealing the tax, and increasing the exemption and/or decreasing the rate. At the same time, some proposals focused on allowing an expanded business exemption.

Despite this attention to family business, evidence suggests that only a small fraction of estates with small or family business interests have paid the estate tax (about 3.5% for businesses in general, and 5% for farmers, compared to 2% for all estates). Recent estimates suggest that only a tiny fraction of family-owned businesses (less than ½ of 1%) are subject to the estate tax but do not have readily available resources to pay the tax. Thus, while the estate tax may be a burden on those families, the problem is confined to a small group.

If the estate tax is repealed, QFOBI will allow an exemption for some or all of business assets in about one-third to one-half of estates with more than half of their assets in these businesses, but the value of the exemption will be reduced because the general exemption has increased. If the estate tax repeal is made permanent, liquidity will cease being a problem, although family businesses may be more likely than other estates to be affected by the capital gains provisions. Exposure to the estate tax, if it is reinstated, would be significantly decreased by increases in either the family business or general exemptions. The report also discusses an uncapped exemption and an uncapped exemption targeted at liquidity issues. This report will be updated as legislative events warrant.

Distributional issues often lie at the center of tax policy debates. Distributional analysis may address several issues: How should the tax burden be distributed or, are progressive (increasing as a share of income as income rises) taxes justified? What is the estimated distribution of the current system? How does a particular proposal change that distribution?

Unlike many analyses that study optimal behavior related to allocative issues and economic efficiency, economic analysis cannot be used to answer the questions of how the tax burden should be distributed. Such an answer would depend on social preferences. Economic analysis can, however, identify trade-offs and frame the issue analytically. For example, a number of plausible answers to this question could justify progressive tax structures.

Methodological issues, such as the income classifier, the unit of analysis, and assumptions regarding incidence all affect the estimates of the distribution of the current tax burden. Yet all show a similar qualitative result: the federal tax system is progressive throughout its range, although it tends to get much flatter at the top. This pattern is primarily due to the individual income tax, which is quite progressive, and actually provides subsidies at lower-income levels. The other major tax is the payroll tax, which is a larger burden than the individual income tax for more than 80% of the population. This tax is first progressive and then regressive (effective tax rates fall with income). The corporate income and the estate taxes, while much smaller, are also progressive, whereas excise taxes are regressive. This overall progressive pattern has been in place historically, and is expected to continue in the future, although effective tax rates are currently low compared with other periods.

Unlike the federal tax system, state and local taxes tend to be regressive. Thus, a progressive federal tax system would be necessary to prevent overall U.S. taxes from being regressive. The combined taxes appear slightly progressive. Looking at taxes from a lifetime perspective would move the system more toward a proportional tax because average lifetime incomes reduces the variability of income. Studies have suggested that overall lifetime taxes are roughly proportional to income.

Many different measures have been used to characterize the effects of a particular tax change on the distribution of income. A very different impression of tax changes may be obtained depending on the measure used. One popular measure, the percentage change in tax, can be misleading, because as taxes become very small even a negligible absolute change in taxes leads to a very large percentage change. For measuring the relative distribution of income, percentage change in disposable income provides a better measure of how resources are distributed. By this measure, the recent tax cuts made incomes less equal.

Wednesday, January 13, 2010

P.L. 107-16, the Economic Growth and Tax Relief Reconciliation Act of 2001, repeals the federal estate tax for 2010 decedents. In addition, the act repealed the credit for state estate taxes for individuals dying after December 31, 2004, and replaced the credit with a deduction. In most states, the repeal of the tax and the significant increase in the federal exclusion will also repeal or diminish state estate, inheritance, and gift taxes. Some state budgets depend on the estate tax more than others. As a percentage of total tax revenue collected from FY2001 to FY2004, state estate tax contributions ranged from 0.19% in Alaska to 3.15% in Pennsylvania. After the federal credit for state estate taxes changed to a deduction in 2005, revenue collected from this tax source declined significantly, and in 2010, 29 states no longer levied estate or inheritance taxes. In the 111th Congress, H.R. 4154, passed by the House of Representatives on December 3, 2009, would permanently set the estate tax exemption level at $3.5 million per decedent, and proposals currently under consideration in the Senate would similarly retain the estate tax after repeal in 2010. This report will be updated as events warrant.

The House and Senate are required under the Congressional Budget Act of 1974, as amended, to complete action each year on a budget resolution before spending, revenue, and debt-limit legislation can be considered. In order to facilitate timeliness in the congressional budget process, Section 300 (2 U.S.C. 631) of the 1974 act establishes a timetable that requires the Senate Budget Committee to report a budget resolution by April 1 and the House and Senate to reach final agreement on a budget resolution by April 15. (Prior to FY1987, the deadline for reporting the budget resolution was April 15 and the deadline for its final adoption was May 15.)

During the 35 years that the congressional budget process has been in effect, the Senate Budget Committee has reported 33 budget resolutions subject to the April deadline. (The budget resolutions for FY1991 and FY2002 were discharged from the committee.)

The 33 budget resolutions were reported, on average, exactly on the deadline. Further, on the basis of averages, compliance with the two deadlines was the same: the averages for the period under the April 15 reporting deadline (FY1976-FY1986) and the April 1 reporting deadline (FY1987-FY2010) were identical—exactly on the deadline.

Twenty-one of the budget resolutions were reported in a timely manner. The reporting date for these budget resolutions ranged from zero to 27 days before the deadline and averaged 12.2 days before the deadline. The remaining 12 budget resolutions were reported from two to 48 days after the deadline, averaging 21.3 days after the deadline. The reporting of the budget resolutions for FY1996-FY1998 was significantly tardy, but the recent record has been much better. The budget resolutions for these three years were reported between 42 days and 48 days after the deadline. Following these three years, however, the measure has been reported on time in 10 of 11 years (the one tardy budget resolution was reported 10 days after the deadline).

The practice of granting a company's employees options to purchase the company's stock has become widespread among American businesses. Employee stock options have been praised as innovative compensation plans that help align the interests of the employees with those of the shareholders. They have also been condemned as schemes to enrich insiders and avoid company taxes.

The tax code recognizes two general types of employee options, "qualified" and nonqualified. Qualified (or "statutory") options include "incentive stock options," which are limited to $100,000 a year for any one employee, and "employee stock purchase plans," which are limited to $25,000 a year for any employee. Employee stock purchase plans must be offered to all fulltime employees with at least two years of service; incentive stock options may be confined to officers and highly paid employees. Qualified options are not taxed to the employee when granted or exercised (under the regular tax); tax is imposed only when the stock is sold. If the stock is held one year from purchase and two years from the granting of the option, the gain is taxed as long-term capital gain. The employer is not allowed a deduction for these options. However, if the stock is not held the required time, the employee is taxed at ordinary income tax rates and the employer is allowed a deduction. The value of incentive stock options is included in minimum taxable income for the alternative minimum tax in the year of exercise; consequently, some taxpayers are liable for taxes on "phantom" gains from the exercise of incentive stock options. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) was enacted. This law included provisions that provided abatement of any taxes still owed on "phantom" gains.

Nonqualified options may be granted in unlimited amounts; these are the options making the news as creating large fortunes for officers and employees. They are taxed when exercised and all restrictions on selling the stock have expired, based on the difference between the price paid for the stock and its market value at exercise. The company is allowed a deduction for the same amount in the year the employee includes it in income. They are subject to employment taxes also. Although taxes are postponed on nonqualified options until they are exercised, the deduction allowed the company is also postponed, so there is generally little if any tax advantage to these options.

This report explains the "book-tax gap" as it relates to stock options and S. 1491 (Ending Excessive Corporate Deductions for Stock Options Act). U.S. businesses are subject to a dual reporting system. One set of rules applies when they report financial or "book" profits to the public. Another set of rules applies when they report taxable income to the Internal Revenue Service. The "book-tax" gap is the excess of reported financial accounting income over taxable income. The following seven key laws and regulations concerning stock options are described: Section 162(m)—"Excessive Remuneration," Sarbanes-Oxley Act: Stock Option Disclosure Reforms, SEC's 2003 Requirement of Approval of Compensation Plans, FASB Rule for Expensing Stock Options, American Jobs Creation Act of 2004 (Section 409A), IRS Schedule M- 3, and SEC's 2006 Executive Compensation Disclosure Rules. Finally, this report examines the issue that some companies backdated options (retroactively selected, without disclosure, dates for granting options) to times when prices of their stock were low.

This report will be updated as issues develop and any new legislation is introduced.